Financial Jungle

Conventional wisdom jibes with the notion that bonds cannot outperform stocks over a distant horizon unless you’re toying with junk bonds. But there’s much more beneath the surface. I feel very fortunate to have *BondGuy, a securities broker, who promises to debunk this investment myth, but he’ll first warm us up with some background information on a special type of bonds that large institutions and the ultra wealthy invest in, namely Collateralized Mortgage Obligations (CMO.) This article is technical and lengthy, but fascinating. BondGuy is available for questions if you’re interested to learn more about CMO. Emphases in the article are mine.

* Replaced with an alias to comply with regulations.

Most of the world’s investors believe the myth that they can’t get a high yield on bonds unless they invest in Junk bonds. They take the risk of losing their initial investment if the issuer goes into default for only 2 or 3% more in interest that they receive for taking that risk. In this post we are going to bust that myth.

Where do we find the strongest credit quality?

First we need to look into finding bonds of the strongest credit quality that will give us a high level of comfort when it comes to the return of our principal. Remember folks, the return of your investment is far more important than the return on your investment. I’ll take an investment that makes a low return over a losing investment any day. Thus, we should stay away from the Junk bonds.

The United States Government and United States Government sponsored agencies hold some of the strongest credit qualities in the world. If we look at corporate bonds you will be hard pressed to find a bond that has received an AAA credit rating for 70 years continuously. Fannie Mae has been around since 1938 and has been AAA rated ever since. Freddie Mac was created in 1970 and has also been AAA rated since inception. Genie Mae is another government agency that was granted full faith and credit of the United States government in 1969 by then attorney general William Rehnquist.

AAA credit ratings are, of course, the safest available. Any credit rating below BBB is considered Junk. There are 3 major credit rating agencies that issue bond ratings in the United States Moody’s, Standard and Poor, and Fitch.

I know that many of the readers of this forum are in Canada. You can be assured that the cities that you live in invest in Fannie Mae and Freddie Mac. Not only municipalities all over the world invest in these bonds, so do pension funds, insurance companies and banks. When I started working in the bond field, some of the largest clients of my first company were banks in Europe. Freddie Mac, Fannie Mae, and Genie Mae make up the system that gives the United States mortgage market its Liquidity. If there was no Fannie, Freddie, or Genie you could go to the bank to borrow money for a home and the banker would probably say they were sorry, but they have no money to lend to you even though your credit is perfect.

When a bank gives a person a home loan they turn around and sell that mortgage to Fannie, Freddie, or Genie at a slightly lower interest rate than they lent the money at. This way the bank has a small piece of interest from the mortgage and Fannie, Freddie, or Genie has given them all of their principal back. The bank can then lend out the same money again.

Freddie, Fannie, and Genie then package these mortgages into bonds and guarantee on time payment of principal and interest. These agencies are allowed to buy very few sub prime loans and have extreme legal oversight from the United States Government. Why such tight regulations on government sponsored enterprises? If Fannie Mae, Freddie Mac, or Genie Mae were to go bankrupt it would cause world wide financial turmoil. Many of the municipalities in the world would go broke. All of the municipalities in the United States would go broke. Your pension plan would be no more (even in Canada). Banks worldwide would go under. These agencies issue and are responsible for making principal and interest payments on trillions of dollars in debt every year and have never missed or been late on a payment. They issue and pay principal and interest on more debt every year than the GDP of many counties. I think we get the idea. The credit quality is extraordinarily strong.

Genie Mae is full faith and Credit of the United States Government. Fannie and Freddie hold what we often refer to as implied full faith and credit of the U.S. Government. We just watched the U.S. Federal Reserve give a large bail out to Bear Stearns because of the negative world wide financial implications. Bear Stearns is tiny in comparison to Fannie or Freddie. The United States government would have no choice but to bail out Fannie or Freddie if they got into trouble. Thus, the term Implied full faith and credit applies to them. I think we now know how strong the credit quality behind these bonds is. Here is a credit rating chart.

Why on earth would a bond issuer with such a high credit rating pay a high rate of return?

The answer to this question is…. they don’t. The high coupons, or interest passed through to the investor in these bonds is paid through cash flow engineering. Cash flow engineering is the slicing and dicing of interest payments on the cash flows from mortgages. It’s a very complex process so we’ll give an example with some simple numbers just to make it easier for me to explain.

A bank will make mortgages at 6 ½ % to the home buyer. They will turn around and sell these mortgages to Fannie, Freddie, or Genie at 6%. So far the mortgage holder will pay the bank 6 ½ % interest plus principal due and the bank will pay Fannie, Freddie, or Genie the principal received and 6% interest keeping ½ % for their profit.

After this takes place Fannie, Freddie, or Genie will group these mortgages into what they call pools and form bonds that pass through interest from those pools. Some of these pools are in the billions of dollars. They will take 90% of these now 6% mortgages and make bonds that yield 5.5% to the investor. So what happened to the extra ½ %? They take that excess interest and pile it on top of the other 10% of the available mortgage pool giving them 51% yield on that small portion; the original 6% that the mortgages naturally pay and 45% that come from the ½ % excess off the other 90% of the mortgages. Understanding how cash flow engineering is done is not really of importance to the investor. You need to know how it works and what it does to bond coupons. You can use a car without knowing how to make one. We’ll get into what the investor needs to understand next.

Why don’t they just sell the bonds that yield 51%?

Sorry guys, it’s an efficient market that operates on the same risk return principals that every investment operates on. But, one of those risks does not have to be losing your initial investment. These bonds take interest rate risk. If rates go up, the coupon will go down and can go to zero on many of them. That’s why I buy these bonds when it looks like rates are going to go down. It’s a lot easier to speculate on rate moves than it is on stock price moves. Interest rates are in the news almost every day. The U.S. LIBOR floats right along with Fed Funds. Fed Funds is the rate that U.S. banks use to lend each other U.S. Dollars overnight. U.S. LIBOR is the rate that European Banks use to lend each other U.S. Dollars overnight. Just wait for the U.S. Federal Reserve to lower Fed Funds, the U.S. LIBOR will follow, and you can make money with these bonds.Thus, the name of these bonds is Inverse Floating Rate Collateralized Mortgage Obligations or CMO’s. Not all CMO’s are inverse floating rate, some are fixed rate and give much lower returns due to the lack of interest rate risk. Not all CMO’s are backed by government agencies like Fannie, Freddie and Genie. CMO’s that are not backed by Fannie, Freddie, or Genie are subject to losing money due to defaults in the sub prime market.

If we want to take risks to get a higher return we should take interest rate risk and always buy the CMO’s that are backed by government agencies. I have bonds in my client portfolios that float inversely to the 1 Month U.S. LIBOR anywhere from 2% to 25% for every 1% that the index moves. This percentage is called the lever. The Federal Reserve has lowered rates from 5.25% to 2.00% since October 2007. Thus the bonds that have the higher levers are getting about 60% coupons currently.

As rates go up the coupons on these bonds will go lower at the same rate that they went up. All inverse floating rate bonds have what we call a strike. The Strike is the point on the LIBOR Index where the bonds coupon will hit zero. If you have a bond with a 4.5% strike and rates are at 4.75% this bond is considered out of the money and will not begin to pay interest again until rates are lower than 4.5%. After rates fall below 4.5 the coupon will increase by the lever amount. For example: If we have a bond with a 4.5 strike and a 15 lever and rates fall from 4.75 to 3.5% over the next several months the interest rate paid to the investor will go from 0% to 15%. If rates go back up over 4.5% the coupon will go back to 0%.

What are the Maturities on these bonds?

We never know what the maturity on a CMO will be. They are made up of 30 year mortgages and the principal and interest payments are passed through to the investor every month. Usually, they take 7 - 12 years to come to maturity.

If they are 30 year mortgages how do they only take 7 -12 years to come to maturity? The average U.S. family lives in a house for 7 years and the home is sold, effectively ending the mortgage contract. The investor receives their principal on that portion of the bond every time a mortgage contract comes to an end. We have what we call the 4 D’s in this market: Divorce, Death, Destruction, and Default. If a couple gets a divorce the home is usually sold. The same happens when someone dies. If a home is destroyed the insurance company pays off the remainder of the mortgage and the contract is over passing that principal on to the investor. If someone defaults, that mortgage contract is done, the bank takes the house, and the investor in the CMO is paid their portion.

Let’s not forget that on time payment of principal and interest is guaranteed by the U.S. government or a U.S. government agency when you buy bonds issued by Fannie, Freddie, or Genie. Another big factor that causes these bonds to pay down faster is refinancing. If a mortgage holder refinances their mortgage the contract is over and the investor in the bond gets that portion of their principal back. Refinancing happens when rates go down and mortgage holders are given the opportunity to refinance it into a lower interest rate.

There are several factors that an investor looks at to estimate when the bond will come to maturity. The first number they would look at is the weighted average coupon, which is the average rate to the mortgage holder. If they have a higher rate they will be more likely to refinance when interest rates go down and the bond will pay off more quickly.

We look at which states the where the mortgages are located. Some states like California and Florida tend to pay down much faster due to real estate speculation. Another factor we look at is which banks made the mortgage loans. The larger banks tend to actively contact there mortgage holders for refinancing purposes. The banks make fee income and the client saves money investing at a lower rate. This also causes these bonds to pay down more quickly. Since refinancing plays a big part in the prepayment of these bonds, and most people don’t want to reinvest in a higher rate mortgage, you run the risk that rates could go through the roof and stay there for 20 years.

Let’s remember that these bonds have an interest rate paid to the investor that floats opposite interest rates. If rates did go through the roof for 20 years you could be holding a non-performing asset for that amount of time. It’s never happened before but the possibility does exist.

How does Bond pricing work with the inverse floating rate CMO?

If interest rates rise, the price on bonds goes down. If interest rates fall, the price on bonds goes up. Since the coupons on inverse floating rate CMO’s can float so far from where market rates are, they have much higher price volatility than normal bonds. If rates are down, I’ve seen some of the higher leveraged bonds priced at 175 cents on the dollar when I only paid 100 cents on the dollar for them several months before. When rates go up I’ve seen these bonds priced at 50 cents on the dollar.

Investing with a bond investor mentality is far different from that of a stock investor. You know that if you hold your bonds to maturity you will get all of your money back as long as we are using government or government agency bonds. If your stock portfolio is down for the month you feel bad, you don’t know when your stock will come back to the price that you paid for it. When you are investing in bonds you have a contractual agreement to give you all of your money back at some point in the future. Not to say I don’t sell on some highs but I don’t worry at all about the lows. The price will come back when rates go back down and we always receive our principal at 100 cents on the dollar. Many of these bonds can be bought at 50 cents on the dollar if rates have gone up and when rates fall the price will go up making a nice buy and sell play. Let’s not forget that when the price goes up, this means we are being paid interest again. If we sell we get the interest up to the point when we sell the bond and the gain form the sale of the bond. I’ve seen 80% returns with this play.

There are other bond plays that can make nice returns.

CMO’s come in many different varieties. We can use Two Tiered Index Bonds (TTIBs) which are CMO’s that will give us a return higher than most junk bonds with AAA credit ratings. Again we will take interest rate risk. With TTIBs we will receive an interest payment until the 1 month LIBOR reaches a certain rate. As of late I have been seeing bonds that will give the investor 7.5% until the 1 month U.S. LIBOR reaches a 6% strike price and then it will start to go down, 8% until the 1 month U.S. LIBOR reaches a 5.5% strike and some that will give the investor 9% until the 1 month U.S. LIBOR reaches a 5% strike. The coupons could fall to 0% if the U.S. LIBOR goes over the strike price.

Another play that many retirees make is in floor bonds. They are inverse floating rate bonds that will give you a minimum coupon and will float up and down inversely 1% for every 1% that the 1 month LIBOR moves. Why would we buy a 6% bond if we could buy one that will give us a 5% minimum but has the potential to give us 10 – 12% at times.

I understand that many of the readers on this site are from Canada. If you invest in this type of bond you will also be subject to currency risk. I am not a currency trader nor do I believe that I have the expertise to inform you about currency risk. I know that currently the U.S. dollar is sliding against foreign currencies. If you plan to invest this type of bond make sure you speak in detail with your financial advisor about inverse floating rate Collateralized Mortgage Obligations before hand. I would be surprised if there is not an equivalent to CMO’s for the Canadian bond market. Unfortunately I don’t know anything about Canadian government issuers but I can’t see a country like Canada doing without them. If you wish to invest in the U.S. bond markets please wait until the price of oil comes down and the U.S. Dollar stabilizes. For those readers who live in the U.S. you have no foreign currency risk.